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Diversification entails investing in a number of investments that behave in different ways in an effort to limit exposure to any single investment or investment style. Diversification can be a key investment-risk management tool.

What Is Diversification?

Diversification is essentially not putting all of your eggs in one basket. In the context of investing, diversification means holding a variety of investments that are not all correlated to each other. A diversified portfolio will contain holdings that will react differently from each other during different types of stock market or economic conditions. 

A portfolio that consists only of large cap, U.S. stocks is not very diversified, for example. 

How to Diversify Your Portfolio

When constructing your portfolio, it's important to include a number of holdings with relatively low correlations to each other. The proper asset allocation will vary from investor to investor. 

Correlation, in an investing sense, refers to the extent that two investments move in relation to each other. A correlation of 1.00 is referred to as a perfect, positive correlation. Two investments with a correlation of 1.00 relative to each other would tend to move in lockstep with each other based on various stock market or economic factors. 

A perfect negative correlation would be -1.00, meaning that the price movement of the two investments would be exactly the opposite under any given set of market or economic factors. 

A correlation of zero means that the price movements of the two investments have no relationship at all. 

The basic asset classes are stocks, bonds and cash. 

For example, large cap U.S. stocks and bonds have a low, negative correlation to each other. 

An investor might have the following holdings in their portfolio: 

  • Vanguard Total Stock Market Index Investor class   (VTSMX)
  • Vanguard Total International Stock Index Investor class  (VGTSX)
  • Vanguard Total Bond Market Index Investor class   (VBMFX)
  • Vanguard Federal Money Market (VMFXX)

The correlation of Vanguard Total Stock Market Index to the other holdings over the 10 years ending Sept. 30, 2019, according to Morningstar data is: 

  • With VGTSX 0.86
  • With VBMFX -0.22
  • With VMFXX -0.03 

The correlation with the total international stock index fund is high as you might expect. With the globalization of companies, markets and stocks developed global markets have a higher correlation with each other than in the past. 

The correlation with the total bond market index fund is both low and negative indicating very little correlation between the price movement of the two funds. The correlation with the money market fund is both negative and close to zero, indicating almost no correlation with each other. 

Looking at the returns of the four funds in 2008, the worst year of the financial crisis, illustrates the differences in returns based on a horrible year for both global stock markets and the global economy. 

  • VTSMX -37.04%
  • VGTSX -44.10%
  • VBMFX +5.05%
  • VMFXX +2.53% 

Clearly investors will want to look beyond one year, but 2008 is an extreme illustration of how differently different types of investments can perform in the same type of economic and market environment. 

What Should Be in Your Portfolio?

What should be in an investor's portfolio will vary based on the investor's goals, time horizon and risk tolerance. 

Depending upon the size of the investor's portfolio and other factors, they might invest in individual stocks, bonds and other instruments. For other investors funds and ETFs may make more sense. The discussion below is largely based on funds. 

An investor with a long time horizon until the money is needed and a relatively high tolerance for risk might have a portfolio that is focused on stocks. Even there, the portfolio will likely have some degree of diversification in that funds or ETFs will hold a number of different stocks offering at least some level of diversification. 

An investor with a lower tolerance for downside risk might have investments like cash or bonds in their portfolio due to their relatively low correlation with stocks. Perhaps this is an investor who is nearing or in retirement. 

Beyond these basic examples, investor's situations will vary all over the board. Within stocks and bonds there are any number of sub asset classes. In the case of stocks there are sub -asset classes within stocks such as: 

  • Large cap
  • Small cap
  • Mid-cap 

Within those sub-asset classes, you can go further based on investing styles: 

  • Value
  • Growth
  • Blend 

Cap size and investment style can also apply in foreign stocks as well. Additionally, within foreign or international stocks there are funds and ETFs that invest in companies in both developed and emerging markets. 

Bonds can vary by duration, a calculation that considers the time until maturity and the cash flows from the underlying holdings in the fund. There are funds that invest in domestic and foreign bonds, Treasuries and other types of governmental bonds, corporate bonds and tax-free municipals among others. 

Even with cash, there are CDs and money market funds. Within money market funds there are different "flavors" investors can choose from. 

Beyond more traditional asset classes accessed via individual holdings or funds, there are a number of alternative assets classes investors can use to diversify their portfolios. Many of these have low correlations to stock and bonds. Some examples include: 

  • Hedge funds
  • Private equity
  • Private debt
  • Real estate (direct investment)
  • Commodities
  • Gold and precious metals
  • Bitcoin and cryptocurrencies 

Again, whether these or other alternatives fit into an investor's portfolio will depend upon their situation, goals, objectives, in some cases the size of their portfolio, risk tolerance and a host of other factors. 

Why Should You Diversify Your Portfolio?

There are many reasons investors should diversify their portfolio, these may differ a bit based upon the investor's situation. A few reasons include: 

  • Controlling downside risk. As mentioned above, asset classes like bonds and cash can mitigate the impact of a falling stock market.
  • Gains can come from a variety of investments. Alternatives can produce gains in addition to more traditional asset classes. Hedge funds, private equity and real estate can be quite lucrative for example.
  • Investments go in and out of favor at different times. Even within the broad category of stocks, different styles rotate into positions of leadership. In recent years large cap stocks have done quite well. Over other periods small caps have been the place to be. 

The problem for investors is that predicting the right investment sector in advance can be difficult. Diversification offers a partial solution to this dilemma.

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